June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 26, 2017

on Monday, 26 June 2017. Posted in 2017, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 26, 2017

Everything in Moderation

“Moderation is the secret of survival.”

                       Manly Hall

 

Stocks continue to set new all-time highs.  All major averages (Dow Industrials, S&P 500, NASDAQ Composite and the Russell 2000) recently made new highs, accompanied by highs in breadth.  Since the beginning of the year the NASDAQ is up 16.4%, reflecting the 19.8% increase in the S&P 500 GICS Technology sector over the same period.  The S&P 500 rose for the seventh straight month in a row in May and has recorded 24 record closes for 2017.  Despite the move to new highs, the recent rate increase at the Fed’s June 14th FOMC meeting and unveiling of their plan for unwinding its balance sheet has diverted attention back to Fed policy and the recent flattening of the yield curve.  The flattening yield curve is often interpreted as a leading indicator of an economic slowdown and eventual recession.  This past week the yield of the 10-Year and 3-Month Treasuries approached their one-year low.  However, according to the Bespoke Investment Group, this is not a forecast for falling stock prices.  They stated that “Instances since 1990 in which the yield curve of the 10-Year and 3-Month Treasury is at 52 week lows the return for stocks was surprisingly good.  The S&P 500 averaged 2.24%, 5.33%, and 9.33% over the next one, three and six months, respectively.”   
 
The bearish view anticipates a flattening of the yield curve to be a precursor of inversion.  The rate increases by the Fed are too slow in an economy experiencing excesses; this is far from the situation today.  The low rate of inflation has misled bears to misinterpret the current moderate flattening.  In this environment we expect that Fed policy will remain data dependent to adequately negotiate the current slow growth situation.   
 
The Moderate Economy
 
The US economy remains at 2% real growth.  There are many different factors limiting the upside, some of these are regulatory and demographic, but in large measure it is the technological advances in the marketplace allowing consumers to purchase more for less.  It has taken nearly 10 years to restore a sense of balance in the economy.  Both banking and housing were, and still are, affected by government banking regulations.  The rise of the largest demographic, 85 million Millennials, is becoming fullfledged participants in the economy and the impact of innovation on everything consumer.   
 
Banking – The enactment of many restrictive regulations during the Great Recession to limit the farreaching “destructive power” of large banks, curtailing risk but at the expense of slow economic growth by the government assuming the role of the private banking system in the recovery.  The current review of Dodd-Frank may lessen some of the more onerous regulations, but a full repeal seems unlikely.  The most recent “Stress Test,” which all banks passed, opened the door of opportunity for banks to seek approval
from the Fed to raise dividends and to initiate new or increase stock repurchases.  This may in part, explain some of the recent flow of funds into the banking sector.   
 
Housing – remains the largest asset for most consumers, but securing the “American Dream” is much harder today than prior to the 2000-2009 fiscal crisis.  The housing market is far from stable.  Needless to say, things are slowly improving as the supply/demand imbalances continue to impede steady growth.  Among these problems are:
 
A.  Regulations.  Mortgage qualifications are much harder on potential homeowners, this has severely impacted first-time buyers.  Building regulations have added up to 25% of the builder’s costs, and to some extent created a shortage in the supply of labor.  This lack of skilled labor has affected primarily small contractors who are unable to continue building houses and have left the market.  This is, in part, the result of the expansion of government disability rolls immediately following the collapse of the housing industry in 2008.  Federal checks in hand, many tradesmen found additional sources of income that enabled them to remain on government assistance.  With the industry in depression for years there were no new workers trained.  Today, a short supply of skilled construction workers are driving builder’s costs higher, not all of which is passed on to home purchasers.   
 
B. The Cost of Homeownership.  With the median prices for new and existing homes at record levels, the percentage of homeownership is at historic lows.  The median price for a new home in May 2017 is $345,800, and for existing homes $254,600, respectively up 16.9% and 5.8% over May 2016. Inventory for new homes is 5.3 months and 4.2 months for existing homes.  The level for existing homes is exceptionally low and has resulted in bidding wars reminiscent of the 2005-2006 housing boom.  Renters are avoiding purchasing homes because of the high prices and according to the National Association of Realtors, only 52% of potential homebuyers feel it is a good time to buy now, this is down from 62% a year ago.  Instead of buyer demand creating supply, the high home prices have created disequilibrium.  Lower priced or starter homes are in short supply as builders target first-time homebuyers rarely pricing homes below $200,000.  Investors take advantage with cash offers to buy lower-priced homes for single-family renters.  An inadequate supply of affordable housing is the problem and although housing data will remain positive, the upward trend will be erratic.
 
 Oil Prices – once again lower prices of crude oil are being touted as an indicator of slower economic growth.  But unlike housing, the problem is oversupply.  OPEC plus non-members led by Russia agreed in May to extend production cuts to reduce global supply by 2% through March 2018.  Since then, overall production has increased as crude has fallen into a bear market.  Today, WTI closed at $43.47 a barrel, down 20.2% from its peak of $54.45 a barrel on February 23, 2017.   US crude rig count peaked at 1,609 in October 2014 and hit a low of 316 in May 2016, the lowest level since the 1940’s.  As of June 23, 2017 the rig count is back to 758.  Breakeven levels continue to fall with about 40% of the decline coming from lower costs from equipment providers.  Technological innovations in fracking have improved decline rates, meaning wells are lasting longer, producing more and fewer wells are needed to increase current output.  Wells are producing below $40 a barrel with some as low as $20 breakeven.  Competition is Saudi Arabia which produces at $23 a barrel.  Aside from lower cost, the improved regulatory environment will add to US production and transport, opening up export opportunities.  Consumers are the major beneficiary, as gasoline demand has risen while maintaining lower prices.  Unfortunately, the Energy sector (XLE) is down 14.7% so far this year.

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies.  To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 13, 2017

on Tuesday, 13 June 2017. Posted in 2017, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 13, 2017

Chicken Little; Short Seller

“The sky is falling.”

                       Chicken Little

 

The selloff that began in technology stocks on Friday and continued through Monday has elicited a broad range of opinions from market strategists.  Those negative on the market seized on the idea that it is a drawdown of the FANG+AAPL+MSFT that is long overdue.  The real bears are not stopping at technology, they believe this trend will broaden beyond to other sectors and expose the “weakening economy and the slowing earnings growth.”  Permabears are already stepping forward to claim the title “I told you so.”  Seems to lack as much credibility after 10 years as Chicken Little did claiming the “sky is falling.”  The conditions initiating the Tech selloff began after noted “activist short-seller” Andrew Left issued a report on chip maker Nividia (NVDA), concluding overvaluation as the primary reason that the chip stocks would go down.  He shorts the stock prior to the report released through his firm Citron Research.  No doubt by conventional fundamentals, NVDA carries a lofty P/E (41.1X), along with a 238% price appreciation over the past year and 50% over the past three months.  Whether the argument on value is valid has little to do with the trade.  Left already alerted other short sellers after taking his position.  For those who missed his call, he had an exclusive interview on CNBC’s “Half-Time Report” on Friday.  By the close, NVDA was down 10%.     
 
This was not Left’s first report on NVDA overvaluation.  In December 2016 he predicted the stock to fall at $90, but it rose to a high of $165. Persistence, capital, and in Left’s, case broad media exposure, are the tools of his trade.  The fact he has made some credible calls on questionable company practices does not always spill over into valuation calls.  But timing is everything.  The Citron report follows Citi, Merrill Lynch and UBS, raising target prices up to the $180’s over the past few days as their previous targets were surpassed.  As mentioned on these pages many times, 85% of hedge fund money is with 5% of the managers.  With about 8,000 hedge funds, that leaves 7,600 managers competing for 15% of the remainder.  Many of these funds are trading firms, including algorithmic and flash traders.  These funds trading long and short and accentuate the movement in both directions.  Performance under these circumstances requires quick moves, getting in early and out before a turnaround.  Smart money has already been made in NVDA.  With all the hype of the recent FANG+2 stocks, it is not surprising for short-sellers to apply the subjective term of overvaluation to tech stocks that have run up nearly 50% over the past year.  There have been rumblings of similarities to the 2000 tech bubble for some time.
 
With regard to the FANG+2 stocks it has come to pass that without overweighting these favorite LargeCap growth stocks, it is virtually impossible to outperform the S&P 500.  While this is true to some degree, but generalization does not take into account that the 50 largest winners in the S&P 500 were up 8.35% year-to-date through April, while the 50 worst performers were off 6.57% over the same period.  It is also interesting that for year-to-date through last Friday, the Equal Weight S&P 500 rose 8.62%, while the Cap Weight S&P 500 was up 8.25%.  Whether the large tech valuations are ahead of fundamentals is a subjective judgement and not a primary consideration for momentum traders.  Academics believe that
an efficient market for stocks exists however, people like Andrew Left have shown value is in the eyes of the beholder or short-sellers.  Others note that the S&P 500 has not had a 5% selloff since July 2016 - - the longest time period since 1996.   
 
The immediate response to the Tech selloff among the many professionals was a reorientation of portfolios away from Tech and into Financials.  This is not readily apparent although there is rationale to such a rotation.  Since the beginning of the year through last Friday, the S&P 500 GICS Financial sector was up 4.1%, while Tech rose 18.6%.  The Fed is expected to raise interest rates 25 basis points this week and, the Comprehensive Capital Analysis and Review is being released by the Federal Reserve on June 28 and many expect the report to show the benefits of lessened regulation; giving economic rationale to rotation.  Also, money managers and individuals hold outsized profits in Large-Cap tech stocks (S&P 500 GICS Technology Sector is up 32.0% year-over-year), an incentive to taking long-term capital gains at current levels.
 
Whatever the reasons for the selloff in the Tech Sector, the companies that have gained 40% or more since the beginning of the year are correcting.  But it will not be long before 2Q2017 S&P earnings are reported.  According to FactSet, current estimates are for a rise of 6.6% for earnings and 4.9% for revenues.  Nine sectors are estimated to show earnings growth, led by Energy (+404.3%), Technology (+9.3%) and Financials (+7.2).  All sectors except Telecom are expected to have revenue increases.   The current Tech selloff should not broaden to other sectors and it is more likely that any rotation will increase purchases in economic sensitive companies rather than out of equities.  The companies experiencing the rapid price depreciation are for the most part, innovative/well-managed and profitable with a growth outlook.  Readjustments of equity prices and sector rotation are common characteristics of bull markets working in conjunction with the business cycle.   
 
By Tuesday, most of the affected Tech stocks have stabilized and reversed course.  There is no guarantee that the selloff is exhausted.  There is a growing recognition that many of these Large-Cap Tech stocks are long-term winners.  The sharp declines on Friday and Monday morning are characteristic of algorithmic trading.  After three days, NVDA is at $150, down from its closing high on June 8th of $160, a day prior to the Citron report.  

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies.  To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens